Financial repression to ease fiscal stress: turning back the clock in the eurozone? Ad van Riet European Central Bank Banco Central do Brasil VIII Annual Seminar on Risk, Financial Stability and Banking São Paulo, 8-9 August 2013 Disclaimer: The views expressed are those of the presenter and should therefore not necessarily be viewed or reported as representing the views of the European Central Bank. 1 Subject of this paper • Following the financial crisis, many advanced countries have to cope with a legacy of high (and still rising) public debt. • Some observers expect a return to financial repression, whereby governments seek to curtail financial markets and exploit their central bank in order to ease their fiscal stress. • This would mean turning back the clock on well-established principles of market freedom and central bank independence. • This paper in the field of institutional economics asks the question: is there evidence of such financial repression to the benefit of governments in the eurozone? 2 How to deal with the legacy of high public debt? • Several ways to cope with a legacy of high public debt: Fiscal austerity to create a primary surplus Sell government assets to reduce gross debt Create higher growth and/or surprise inflation Reduce effective interest rate paid on debt • History shows that governments may also resort to financial repression to secure debt financing at low interest rates, or even their solvency. This would show up in pervasive financial market interventions and instructions to the central bank. • Applied during/after WW I and II, but discarded after1980 as markets were liberalised, central banks gained independence and governments subjected themselves to market discipline. 3 Financial repression: for good or for ill ? Two ways to see the concept of financial repression: 1. As a ‘public service’ in the interest of society • Curtailing markets may be needed in times of crisis and war • Markets must be regulated and supervised to ensure financial stability • Central bank needs leeway to use unconventional monetary policy tools • Targeted interventions may seek to correct excessive income/wealth trends 2. As a ‘public vice’ in the government’s own interest • Allocates savings to the government at below-market interest rates • Creates undue government privileges to evade market discipline • Causes central bank to deviate from its monetary policy mandate • Leads to market distortions and mostly hidden income/wealth redistribution Criteria to assess whether repressive measures are good or bad: • do they support efficient functioning of financial markets and institutions, and • do they respect central bank independence in a credible manner? 4 Examples of repression of the financial system • Faced with a fiscal crisis governments (and national regulators) will use their vast powers to fend off market pressure. • Many repressive tools create undue privileges for governments: - moral suasion: exercising pressure to ‘voluntarily’ invest in government bonds - financial legislation: prudential rules that suppress sovereign risk, or investment constraints favouring government debt, creating a captive investor base - market interventions: to cap bank deposit rates and steer savings to government - credit controls: to steer bank lending to state companies and strategic sectors - Tobin tax: taxes on financial assets or transactions to throw ‘sand in the wheels’ of finance, while also exempting holdings of or transactions in government bonds - capital levies: to confiscate private sector wealth to reduce a public debt overhang - public debt restructuring: violating contracts, subordinating private debt holders - capital controls: to prevent outflows and create a captive domestic investor base. • They distort market signals and raise moral hazard, as they curb market-based fiscal discipline and weaken reform incentives. • Leads to a largely hidden redistribution of income and wealth. 5 Examples of political pressure on the central bank • Governments may also demand central bank support when they face high funding costs, are close to default, or have lost room for fiscal manoeuvre. • Even when independent by law, a central bank may face strong political pressure in a financial, banking and fiscal crisis to - guarantee that government bonds will remain ‘safe assets’ - cap government bond yields or reduce them below their ‘fair value’ - undertake large-scale purchases of government bonds in the market - offer monetary financing of a fiscal impulse to stimulate demand - provide capital support to fragile banks and state companies - impose credit controls to steer bank lending to favoured sectors - to generate excess inflation or nominal GDP growth - engineer an artificial currency depreciation. • A central bank’s independent crisis response is a balancing act between securing financial stability and monetary stability; its credibility is more at risk, the longer its exceptional measures remain in place and cause unintended side effects. 6 Financial repression as a source of public revenues The government’s repressive interventions secure special benefits by effectively imposing a tax on the financial system and an inflation tax on the economy. Government (income from financial repression tax) Financial repression Financial system Central bank (implicit or explicit tax payments) (seigniorage from inflation tax) 7 Scope for financial repression in the eurozone? • EU Treaty offers little scope for financial repression to ease fiscal stress, as it sets rules for sound public finances, subjects governments to market discipline and supports open markets: - No excessive deficits: need to adhere to a close to balanced structural budget - No preferential access: governments get no favours from financial institutions - No bail-out rule: countries are not allowed to take over each other’s liabilities - No direct monetary financing: ECB is independent from political pressure - No financial protectionism: free flow of capital within the Internal Market. • However, some ‘openings’ in EU law can be detected: - Peer pressure on countries and enforcement of the EU fiscal rules is weak - Preferential access to financial institutions is accepted for prudential purposes - Countries may give each other temporary conditional loans on market terms - ECB is allowed to intervene in secondary markets for monetary policy purposes - Coordinated financial taxes may be targeted at destabilising speculative forces - Capital controls may be reinstated for the public interest and as EMU safeguard. • They allow for ‘good’ financial repression to maintain/restore stability in times of stress, but may also create ‘bad’ government privileges. 8 Eurozone incentives for financial repression • Financial crisis is blamed on excessive risk-taking by the financial sector, ‘too-big-to-fail’ banks had to be rescued by taxpayers; perception of severe market and regulatory failures. • The euro area sovereign debt and banking crisis caused extreme market volatility, severe funding stress, capital flight and rising bond yields, fuelling fears of self-fulfilling sovereign default. • Given contagion, this in turn triggered fears of a break-up of the euro, while growing financial market fragmentation hampered monetary transmission across the eurozone. • Policy-makers intervened in response to this destructive market mechanism to secure financial, fiscal and monetary stability. • Did they also create unwarranted privileges for governments? 9 Several euro area countries faced fiscal stress Faced with rising public debt, several countries were faced with market pressure and a sovereign debt crisis, fuelled by a vicious feedback loop with a fragile banking sector Gross government debt of euro area countries, 2007 and 2012 (% of GDP; Euro area countries are shown using their country code. EA stands for euro area average) 10 Contagion and systemic fragility of the eurozone Euro area sovereign bond markets failed to recognise build-up of credit risk before the crisis, as shown by undue yield compression. Afterwards, markets were overshooting. This triggered self-fulfilling default expectations, showing systemic fragility of eurozone. Government bond yields of euro area countries, Jan. 1992 - May 2013 (10-year maturity in %; yields for CY, EE, LU, MT and SI are excluded owing to infrequent or a lack of observations) 11 Cases of financial repression at national level? Aim: fight fiscal stress; create a captive domestic investor base, fill budget holes, avoid costly bank rescues, cut public debt overhang • Affecting domestic banks - Moral suasion of banks to take advantage of cheap Eurosystem liquidity offered at exceptional three-year maturity and to park this in government bonds (ES, IT) - Cap on bank deposit rates temporarily made investing in government bonds relatively more attractive (ES) - Reports of supervisory pressure on banks to withdraw their foreign assets in the vulnerable countries, or to repatriate funds held in subsidiaries/branches in the stronger countries • Affecting domestic pension funds - Moral suasion of pension funds to invest at home, in government bonds (IE, PT, ES) - Use of pension reserves to fill holes in the government budget (FR, IE, PT, ES) • Affecting savers and investors - Capital levy on insured bank deposits below €100.000 (proposal was rejected by CY parliament, but still necessitated capital controls to prevent deposit outflows) - ‘Voluntary’ public debt restructuring violated private investors’ contract rights (GR, CY) 12